306 Glossary Parity An in-the-money option with no time premium that consequently has a 100 per cent correlation with the underlying. Pin risk The risk of an underlying closing exactly at the options strike price at expiration. The risk lies primarily with the short option holder because he is uncertain of assignment. Put A put option is the right to sell the underlying asset at a specified price for a specified time period. The put buyer has the right, but not the obligation, to sell the underlying. The put seller has the obligation to buy the underlying at the put buyer’s discretion. Put spread A long put spread is a long put plus a short put at a lower strike. A short put spread is the opposite. Reversal Short underlying plus long synthetic. Rho The change of an option’s value through a change in the interest rate. Short To short is to sell. A short futures contract sells a cash or physical asset when the contract expires. A short options contract sells the right to buy, for a call, or the right to sell, for a put. Short deltas Any combination of short calls, long puts and short underlying. Stop order An order to buy or sell at the market price when a market reaches a pre-specified price level. Straddle A call plus a put at the same strike, both either long or short. Strangle An out-of-the-money call plus an out-of-the-money put, both either long or short. Strike price The price of the underlying that forms the basis of an options contract. Synthetic call A long synthetic call is a long put plus a long underlying. A short synthetic call is a short put plus a short underlying. Synthetic put A long synthetic put is a long call plus a short underlying. A short synthetic put is a short call plus a long underlying. Synthetic underlying A long synthetic is a long call plus a short put at the same strike. A short synthetic is a short call plus a long put at the same strike. Sometimes referred to as the combo. Theta The amount that an option decays in one day. Theta/price ratio The percent of an option’s value diminished by one day’s time decay. Glossary 307 Time decay The decline in an option’s value through all or a portion of the option’s life. Usually expressed as theta. Time premium The premium apart from intrinsic value of an option. The amount of an option’s value that corresponds to volatility coverage. Time spread See Calendar spread. Underlying An asset upon which an option’s value is based. This can be a stock or stock index, bond, commodity or futures contract. Vega The amount that an option changes through a 1 per cent change in the implied volatility. Vega/price ratio The percent that an option’s value changes through a 1 per cent change in the implied volatility. Vertical spread A call or put spread. Volatility A one-day, one standard deviation move, annualised. Volatility, historical Volatility averaged over a time period such as 10, 20 or 30 days. Volatility, implied The volatility that is implied by an option’s price. In the case of an ATM option, this is the expected historical volatility of the underlying through expiration. Volatility skew A pattern of implied volatility variations exhibited by in-the-money and out-of-the-money options. Further reading There are now many helpful books on options, and below are a few that can be recommended. Also included are books of a more general interest in order to help you make trading decisions. They all are, or will be, clas- sics. The list is limited because your time is limited, and your priority is to take the shortest route to a more advanced level. Technical books Option Volatility and Pricing (1994) by Sheldon Natenberg, McGraw-Hill. An excellent next step Options, Futures and Other Derivatives (2009) by John Hull, Prentice Hall. Another classic. For those with an advanced mathematical background Paul Wilmott Introduces Quantitative Finance (2007) by Paul Wilmott, John Wiley & Sons. Heavy on the maths, but readable. Wilmott is a super-quant. Technical Analysis of the Financial Markets by John J. Murphy, New York Institute of Finance. Thorough and readable An Introduction to the Global Financial Markets (2010) by Stephen Valdez, and Philip Molyneux, Palgrave Macmillan. A first-rate intro to this business. Options Plain and Simple (2000) by Lenny Jordan, Prentice Hall. A classic, generally agreed. Some traders have read it three times. Just get over the fractions. Further reading 309 Books about trading The Gambler by F.M. Dostoyevsky (various editions). To know the difference between trading and gambling. Reminiscences of a Stock Operator (2004) by William J.O’Neil and Edwin Lefevre, John Wiley & Sons. A classic, for market awareness about stock manipulators. The Big Con (2000) by David W. Maurer, Arrow/Random House. Written in the 1930s. Anyone involved in the Bernie Madoff scandal could read this and weep. The rest of you should read it before you contract a financial adviser. Traders’ website www.nakedtrader.com Mostly about cash futures trading, but very helpful with technical analysis. It will also bring you into the mind of the trader. And finally… The Meditations of Marcus Aurelius (various editions). Advice from a battle-hardened emperor. Stoicism will help you manage your self. agricultural commodities 159–60 American-style options 34, 35, 140, 141, 160, 305 boxes, trading 240 put–call parity 232 analysis of a trade 183–5 arbitrage 234–5, 237, 239 asymmetric or broken ladder 97, 307 long iron butterfly 123 at-the-money (ATM) 10, 26, 198, 305 boxes, trading 240 calendar spread 157, 158, 305 delta 48, 49, 50, 165–9, 306 delta price ratios 178, 306 delta vs gamma, theta and vega 169 early exercise premium 35 gamma 54–7, 165–9, 307 implied volatility vs Greeks 172 long at-the-money call butterfly 131, 132 long at-the-money call condor 143 long at-the-money put butterfly 135 long at-the-money put condor 145 long diagonal call spread 160 long iron butterfly 121 long straddle 110, 112, 113 pin risk 33, 140, 308 short at-the-money call and put butterflies 136 short straddle 114 theta 59, 165–9, 308 time decay 28, 309 time premium 27, 309 vega 64, 66, 165–9, 189, 309 VIX 185 volatility skews 202, 206, 208, 209, 210, 212, 214, 309 bear spreads, list of 70 bear/long put spread 73–4, 78–80, 196, 197 1×1s and volatility skews 83 short vs long 81–2 strikes 82–3 bear/short call spread 73–4, 76–8, 196 long vs short 81–2 strikes 82–3 bell curve 37–9, 44–5 Black-Scholes model 34, 41, 232 bonds futures contracts 222 volatility skews 199–201, 207, 210–11, 309 boxes 305 cost of carry on 240 long 233, 237–8 short 233, 239 trading 239–40 break-even level calls 11, 306 condor with non-adjacent strikes 148 covered write 152–3, 156, 306 Index Page numbers in bold indicate a glossary entry. Index 311 hybrid spreads 107, 108, 307 lo ng 1×2 call spread 86 long 1×2 call spread for a credit 88 long 1×2 put spread 89 long at-the-money call butterfly 133 long at-the-money call condor 143 long at-the-money put butterfly 135 long at-the-money put condor 146 long call, short put combo 102 long call spread 75 long iron butterfly 122 long iron condor 128, 129 long ladder/Christmas tree 92, 94, 96, 97 long out-of-the-money call butterfly 138 long out-of-the-money call condor 141–2 long out-of-the-money put butterfly 139 long out-of-the-money put condor 144 long put, short call combo 104, 105 long put spread 79 long straddle 111, 112 long strangle 116 puts 21, 22, 197, 308 short at-the-money call condor 147 short call spread 77 short iron butterfly 124, 125 short iron condor 126, 128 short put spread 81 short straddle 114 short strangle 118, 119 broken or asymmetric ladder 97 long iron butterfly 123 bull spreads, list of 70 bull/long call spread 73–6, 195 1x1s and volatility skews 83 short vs long 81–2 strikes 82–3 bull/short put spread 73–4, 80–1, 197 long vs short 81–2 strikes 82–3 butterfly 131, 160, 305 additional risks with 140–1 advantages 149 iron see separate entry long at-the-money call 131–4 long at-the-money put 135–6 long out-of-the-money call 137–8 long out-of-the-money put 138–9 non-adjacent strikes 147–8 short at-the-money call and put 136–7 take a gift 139–40 volatility, dates until expiration and 149 buy-stop 91, 101, 196 buy-write 151–5 risk management 155–7 calendar spread 151, 157–9, 305 risks 159–60 calls 306 at-the-money 10, 26, 198, 305 buying 9–12 common characteristics of puts and 17 comparison of puts and 24 everyday example 4–5 in-the-money 10, 26, 307 long position 24 misconceptions 197–8 naked 13, 307 offering 8–9 out-of-the-money 10, 26, 307 owning 7–8 problems 195–6 selling 12–14 short position 24 summary 14–15 cash payment dividends, interest rates and margin vs 29–30 Chicago Board Options Exchange (CBOE) contract multiplier 12 European and American style 34, 35 312 Index Chicago Board Options Exchange (CBOE) (continued) SPDR (‘Spider’) 74, 148 SPX options 34, 148, 236, 240 Vix 185 Chicago Board of Trade (CBOT) exercise and assignment 31–2 terms used for spreads 72 Christmas trees see ladders collar 104–6 combo 306 long call, short put 101–4 long put, short call 104–6 commodities 155, 159–60 futures contracts 222, 223 problems 197 volatility skews 83, 204–6, 207, 214 common problems with call and put positions 195–7 condor 131, 160, 306 advantages 149 iron see separate entry long at-the-money call 143 long at-the-money put 145–6 long out-of-the-money call 141–2 long out-of-the-money put 144–5 non-adjacent strikes 147–8 short at-the-money call 147 short at-the-money put 146 volatility, dates until expiration and 149 contingency plan 91 contract liquidity and market making 194–5 contract multiplier 10, 12 conversion 233–5, 306 reverse 233, 235 cost of trading 177, 181 price movement 177–8 time 178–9 volatility 179–81 covered write 151–5, 306 risk management 155–7 crises 157, 206, 223 emerging market (1997) 35–6 currencies futures contracts 222 cylinder see combo delta 175–6, 306 calendar spread 159, 305 definition and examples 47–9 equivalence to underlying 50–1 hedge ratio 51 implied volatility changes 173–4 implied volatility vs 170–3 long 1x2 spreads 91 long straddle 112 neutral 35–6, 51 price ratio 177–8, 181 probability 51–2 summary 52 time and 165–9 time decay 49–50, 309 vs gamma, theta and vega 169–70 diagonal call spread 160 direction, market long and short 30 dividends 159, 237 futures contracts 223 margin vs cash payment, interest rates and 29–30 durational outlook 190, 243 early exercise premium 34–5, 240 emerging market crisis (1997) 35–6 ESX options 34 Eurodollars 32, 33, 194 volatility calculation 40 European-style options 34, 236, 240, 306 fence 104–6, 306 fixed amount to invest conclusions 181 delta price ratio 177–8, 181, 306 theta price ratio 178–9, 181, 308 two approaches 181 vega price ratio 179–81, 309 Index 313 FTSE European-style options contract 240, 306 FTSE-100 34, 236 futures contract 221–2 example 222–3 initial margin 222 synthetic see separate entry valuation formula 223 variation margin 222 futures options early exercise premium 34 exercise and assignment 31–2 margin vs cash payment 29 pin risk 33, 308 gamma 47, 110, 307 definition and examples 53–6 delta versus 169–70 implied volatility vs 170–3 long straddle 57, 112 positive and negative 56–7, 58 short straddle 57 strangle 57, 308 time and 165–9 volatility trading 57–8 Greeks 175–6 delta see separate entry delta vs gamma, theta and vega 169–70 gamma see separate entry implied volatility changes 173–4 implied volatility vs 170–3 long iron butterfly 122 options calculator 175 other 174 rho 174, 308 spreads 74, 78, 85, 89 theta see separate entry time and 165–9 vega see separate entry hedge ratio 51 hybrid spreads 106–8, 307 in-the-money (ITM) 10, 26, 307 boxes, trading 239–40 butterfly 140, 141, 305 cost of carry discount 29 delta 48, 49, 51–2, 165–9, 187, 306 delta price ratios 178, 306 early exercise premium 34–5 gamma 53–6, 165–9, 307 implied volatility vs Greeks 171, 172 long at-the-money put butterfly 135 long and short spreads 82, 83 premium 26–7, 34–5 put–call parity 232 theta 59, 165–9, 308 time decay 28, 309 vega 64, 165–9, 309 interest rate contracts, long-term 207 interest rate contracts, short-term 159 cash settled contracts 31, 32, 33 volatility calculation 40 interest rates 223 calendar spreads 159, 305 implied volatility 174 margin vs cash payment, dividends and 29–30 rho 174, 308 intrinsic value 26–7, 307 iron butterfly 121, 307 long 113, 121–3, 125 long broken 123 short 116, 124–5 iron condor 121, 307 long 118, 128–30 short 118, 125–8 ladders 307 asymmetric or broken 97 comparing call spreads, 1x2s and 97–9 different strike prices 96 long call 91–4 long put 94–6 risk management 96 leverage 193–4, 307 314 Index LIFFE European-style option 34, 306 margin on futures options 29 terms used for spreads 72 long 1×2 call spread 85–7, 91, 97–9 call spread for a credit 88, 91, 97–9 put spread 88–91, 97–9 long at-the-money call butterfly 131–4 call condor 143 put butterfly 135–6 put condor 145–6 long box 233, 237–9 long calendar/time spread 151, 157–9 risks 159–60 long call butterfly 91 long call condor 96 long call ladder/Christmas tree 91–4 asymmetric or broken ladder 97 comparing call spreads, 1×2s and ladders 97–9 different strike prices 96 risk management 96 long call spread 73–4, 195 1×1s and volatility skews 83 bullish strategy 74–6 short vs long 81–2 strikes 82–3 long diagonal call spread 160 long iron butterfly 113, 121–3, 125 long iron condor 118, 128–30 long out-of-the-money additional risks of butterfly 140–1 call butterfly 137–8 call condor 141–2 put butterfly 138–9 put condor 144 take a gift: butterfly 139–40 long position 24, 30, 221 long put butterfly 91 long put condor 96 long put ladder/Christmas tree 94–6 asymmetric or broken ladder 97 comparing call spreads, 1×2s and ladders 97–9 different strike prices 96 risk management 96 long put spread 73–4, 196, 197 1×1s and volatility skews 83 bearish strategy 78–80 short vs long 81–2 strikes 82–3 long straddle 57, 110–13 long strangle 116–18 margin 307 futures contracts: initial and variation 222 interest rates, dividends and cash payment vs 29–30 market direction long and short 30 market-makers 233 contract liquidity 194–5 delta neutral 35, 306 puts 22, 308 short at-the-money butterflies 137 short at-the-money put condors 146 synthetic positions 221 trading boxes 239 misconceptions call and put positions 197–8 models, pricing 34, 41 volatility see separate entry monthly results 190–1 multiplier 10, 12, 307 naked 307 selling calls 13, 73 selling puts 22–4 OEX 34 boxes, trading 240 butterflies 140, 148, 305 calendar spreads 160, 305 cash settled contracts 32 condors and butterflies with non- adjacent strikes 148 conversion and reversals 236 early exercise premium 35 Index 315 put–call parity 232 volatility skews 202–3, 309 one by one directional spreads 83, 206 comparing call spreads, 1x2s and ladders 97–8 one by two directional spreads 85 comparing call spreads, 1x2s and ladders 97–8 long 1×2 call 85–7, 91, 97–9 long 1×2 call spread for a credit 88, 91, 97–9 long 1×2 put 88–91, 97–9 long call ladder/Christmas tree 91–4, 96–9 long put ladder/Christmas tree 94–9 risk management 91, 96 options calculator 175 out-of-the-money (OTM) 10, 26, 195, 196, 307 calendar spread 158, 305 delta 48–9, 165–9, 306 delta price ratios 178, 306 delta vs gamma, theta and vega 169 early exercise premium 35 fixed amount to invest 178, 181 gamma 53–5, 165–9, 307 implied volatility changes 174 implied volatility vs Greeks 171, 172 interest rate component of price 30 long 1×2 spreads 91 long at-the-money call butterfly 132 long call, short put combo 101 long diagonal call spread 160 long iron condor 128 long ladder/Christmas tree 92, 96 long out-of-the-money call butterfly 137 long out-of-the-money call condor 141 long out-of-the-money put butterfly 138 long put, short call combo 104 long and short spreads 82, 83 long strangle 116 short iron butterfly 125 short iron condor 125–6 theta 59, 165–9, 308 time decay 28, 309 time premium 26, 309 vega 64, 165–9, 189, 309 volatility skews 211, 213, 309 outlook, durational 190, 243 parity 27, 308 patience 190–1 pin risk 33, 72, 140, 233, 239, 308 portfolio insurance 156–7 premium 26–7 delta and time decay 49–50 early exercise 34–5, 240 time decay see separate entry pricing and behaviour 35–6 Black-Scholes model 34, 41, 232 early exercise premium 34–5 European vs American style 34 exercise and assignment 31–2 interest rates, dividends and margin vs cash payment 29–30 intrinsic value 26–7, 307 long and short options positions 30 models 34, 41 pin risk 33, 72, 140, 233, 239, 308 premium 26–8, 34–5 price levels 25–6 risk plan 35–6 time premium 26–7, 309 see also delta; gamma; theta; vega; volatility and pricing models probability delta and 51–2, 306 theta and 60, 308 problems 241–2 with call and put positions 195–7 put–call parity 231–2 puts 308 at-the-money 26, 198, 305 buying 17–20 common characteristics of calls and 17 [...]... 157–9, 309 risks 159–60 trading options buying an option 187–8 317 318 Index trading options (continued) durational outlook 190, 243 options vs basis points 190–1 selling an option 188–9 terms to use 71–2 trading delta and time decay 187 trading volatility trends 189 volatility skews 206, 211–15 underlying asset 7, 25, 243, 309 vega 47, 110, 189, 309 calendar spread 159, 305 definition and examples 63–5... 214 expiration, behaviour towards 208–9 interest rate contracts, long-term 207 market sentiment 214–15 put skew 197, 201, 207, 210, 214 reasons for 206–7 stock indexes 202–3, 207, 210, 214 stocks 204 trading 206, 211 trading options on linear skew 213–14 trading options on positive skew 211–13 underlying, shift with 209–10 vertical shift 210–11 volatility spreads 44, 69, 309 definitions of volatile and... options 34, 148, 236, 240 starting to trade advice 72, 242–3 list of spreads 70 spreading risk 69–70 stationary definition of 110 list of spreads 70 stock indexes 31 butterfly 141, 305 calendar spreads 159, 305 cash settled contracts 31, 32, 33 common problems 195–7 conversion and reversals 236 early exercise premium 35 futures contracts 222, 223 interest rates, dividends and margin vs cash payment 29–30...316 Index puts (continued) comparison of calls and 24 everyday example 3–4 in- the-money 26, 307 long position 24 misconceptions 198 out-of-the-money 26, 307 problems 196–7 selling 20–4 selling naked 22–4 short position 24 short put spread 23 strategy 22–4 summary 24 resting buy order 101 sell order 104 reversal 233, 235, 236, 308 rho 174, 308 risk/return potential 24, 69, 72, 83, 149 buying a call... 229–31 short call position 228 short put position 154, 230–1 stock options 226 takeovers 159 technical analysis 183–5, 196 terms to use placing spread orders 71–2 theta 47, 110, 308 definition and examples 58–9 delta versus 169–70 implied volatility vs 170–3 long strangle 118 price ratio 178–9, 181 short strangle 118 time and 165–9 use and abuse of 59–61 time decay 27–8, 309 delta 49–50, 306 gamma 54,... 210, 214, 309 stock options calendar spreads 159, 305 common problems 195–7 conversion and reversals 236–7 early exercise premium 34 exercise and assignment 31 interest rates, dividends and margin vs cash payment 29–30 pin risk 33, 308 put–call parity 232 synthetic/combo 226 volatility skews 204, 309 stop-loss 243 calls 11, 306 long put, short call combo 104 short call spread 76, 83 Index short iron... 81–2 neutral to bearish strategy 76–8 strikes 82–3 short iron butterfly 116, 124–5 short iron condor 118, 125–8 short position 24, 30, 221 short put spread 73–4, 197 long vs short 81–2 neutral to bullish strategy 80–1 strikes 82–3 short sterling contracts 32, 33 short straddle 57, 114–16 short strangle 118–19 SPDR (‘Spider’) 74, 148 spreading risk 28, 69–70 list of spreads 70 terms to use 71–2 SPX... risk/return of 66 short strangle 118 time and 165–9 vertical spreads 73, 309 VIX 185 volatile market spreads, list of 70 volatility and pricing models 34, 37–9 bell curve 37–9, 44–5 comparing historical and implied volatility 43 conventional usage 43 historical volatility of underlying 39–41, 43 implied volatility 41–3, 170–4, 175 numa.com 42 volatility skews 42, 49, 83, 196, 199, 309 1×1s and 83, 206 at-the-money... 112–13 long strangle 117 plan to cover risk 35–6, 91 puts 19, 21, 308 selling a call 13 selling a put 21 short at-the-money call condor 147 short at-the-money call and put butterflies 136–7 short call spread 77 short iron butterfly 124, 125 short iron condor 127 short put spread 81 short straddle 114, 115 time decay 28, 309 volatility 44, 309 seasonal volatility trends 160 sell stop order 155 short at-the-money... summary 24 resting buy order 101 sell order 104 reversal 233, 235, 236, 308 rho 174, 308 risk/return potential 24, 69, 72, 83, 149 buying a call 10 buying a put 19 calendar spread 159–60, 305 calls 10, 13, 306 condor with non-adjacent strikes 148 contingency plan 91 covered write 155–7, 306 Greeks see separate entry hybrid spreads 106, 307 long 1×2 call spread 86 long 1×2 put spread 90 long 1×2 spreads . 10 9 10 short straddle 57, 11 4 16 short strangle 11 8 19 theta 11 0, 11 8, 308 vega 11 0, 11 2, 11 8, 309 volatility trends seasonal 16 0 trading 18 9 weekly or monthly results 19 0 1 . 206–7 stock indexes 202–3, 207, 210 , 214 stocks 204 trading 206, 211 trading options on linear skew 213 14 trading options on positive skew 211 13 underlying, shift with 209 10 vertical. shift 210 11 volatility spreads 44, 69, 309 definitions of volatile and stationary 11 0 gamma 57–8, 11 0, 11 2, 307 long straddle 57, 11 0 13 long strangle 11 6 18 market volatility 10 9 10 short